Imagine a scenario where a McDonald’s franchisee, who owns 12 stores (and the land they sit on), gets a letter from their corporate partner that says they must remodel all 12 of their stores to bring them up to current branding standards. The total cost of the renovations is $1,000,000, which the owner does not have. But, if the stores are not remodeled within a certain period of time, they risk fines, penalties, and even the potential loss of their license. This scenario is not uncommon in the commercial real estate (CRE) industry, but the good news is that the franchisee has a number of ways to get the money for the required renovations.
One of the ways they can finance the remodel is through a type of real estate transaction known as a “sale-leaseback.” In this article, we will define what a sale-leaseback is, how they work, their risks and benefits, and how to gain exposure to them through private equity real estate transactions. By the end, readers will have the information needed to determine if this type of transaction is a good fit for their own real estate investment objectives.
At First National Realty Partners, we specialize in the purchase and management of grocery store anchored retail centers, which may occasionally involve a sale-leaseback transaction. To learn more about our current investment opportunities, click here.
What is a Sale-Leaseback Transaction?
A sale-leaseback transaction is exactly what it sounds like. In it, an individual or company sells a property to a buyer and then immediately leases it back from them.
How Sale Leasebacks Work
To illustrate how a sale-leaseback transaction works, let’s go back to the example in the introduction. An individual owns 12 McDonalds stores and they need $1,000,000 to fund renovations to them.
To get the needed funds, they could sell their stores, individually or in bulk, to an investor for current market prices, which will unlock the equity tied up in the real estate. Then, they will sign a series of long term real estate leases with the acquiring investor to lease the space back from them so their stores can continue to operate.
The sales price, lease term, and lease payments will all be negotiated ahead of time so that the transaction is seamless for both parties.
Pros & Cons of a Sale-Leaseback Transaction
For the property owner, the major benefit of a sale-leaseback transaction is that they get a major influx of capital upon the sale of their real estate assets. In the example above, the franchisee can get the money they need for remodeling without having to take out an expensive loan.
For the investor/purchaser, there are two benefits. First, they have an opportunity to add a series of commercial properties to their own balance sheet, which is always a good thing. Second, and perhaps more importantly, they do so with the security of knowing that the properties are immediately going to be leased, which gives them an instant stream of rent payments, cash flow and revenue. Often, lease agreements are for multi-year periods (with additional renewal options), which has a stabilizing impact on the property’s value.
For the property owner, the primary downside to a sale-leaseback is that they relinquish ownership of their property. This can be a major asset whose market value improves over time and selling it may be much more expensive than a loan over time based on loss of future price appreciation. But, they may justify it by saying, real estate investment is not our core business so we will let someone else handle that and we will stick to our core competencies (as is the case in the example).
For the purchaser, the downside is that they now have to take on the risk of owning the properties. In the example above, suppose that the franchisee invests the $1,000,000 in the required renovations, but their business does not improve. In fact, it declines to a point where they can no longer afford the rental rate outlined in the lease. If they default, the new property owner now has to do all of the work of finding a new tenant and remodeling the property again. This is a real risk that can cause the occupancy and market value of their investment to decline.
Why Investors Might consider a Sale-Leaseback Transaction
From a commercial real estate investment standpoint, there are a number of potential benefits to a sale-leaseback arrangement. They include:
- Income: The lessee pays rent each month and, if there is money left over after operating expenses are paid, it is distributed to investors/owners on a regular basis. These payments can create an income stream, which can provide a nice return on investment.
- Tax Benefits: Ownership can come with a number of tax benefits including depreciation, deductible operating expenses, and the ability to defer income taxes on a profitable sale through a program like a 1031 Exchange.
- Confidence: The lease is executed at the same time as the sale or shortly thereafter, which eliminates vacancy risk for the new owner, at least in the short term. In addition, the property may have a long history of successful operations. Both of these points can give investors confidence that the property will perform as expected.
- Mortgage Financing: Finally, because the property will be immediately leased, the consistent cash flow can also give lenders the confidence needed to finance the deal.
Of course, a sale and leaseback transaction can also have its own share of risks, but they are not unique to the transaction type. They include the same type of vacancy, market, and interest rate risks that are seen in all commercial real estate transactions.
Sale-Leaseback Transactions & Private Equity Real Estate
A private equity firm is one that invests in the equity of other companies, including those that own real estate. Depending on the firm, they may pursue different investment strategies, including those that involve the sale and leaseback of commercial properties.
For individual investors who like this strategy, the benefit of working with a private equity firm is that they have the relationship network, financial resources, experience, and expertise necessary to find, underwrite, and manage real estate sale-leaseback transactions. For individuals, it can be difficult to gain access to these types of transactions and working with a private equity firm can make it much easier.
Summary & Conclusion
A sale-leaseback is a commercial real estate transaction that involves the sale of a property and the simultaneous lease back of the same property from the new owner.
For business owners, this type of transaction can help bring liquidity to a traditionally illiquid asset. Often, these funds are needed to pay for other operational expenses. But, they may forsake future gains to get them.
For investors, this type of transaction can add valuable real estate to a growing portfolio and provide a consistent source of cash flow from a lease structure that is signed at closing.
For investors, one of the ways to gain exposure to this type of real estate transaction is to partner with a private equity firm who has the experience, resources, and expertise necessary to execute this type of transaction.
Interested In Learning More?
First National Realty Partners is one of the country’s leading private equity commercial real estate investment firms. With an intentional focus on finding world-class, multi-tenanted assets well below intrinsic value, we seek to create superior long-term, risk-adjusted returns for our investors while creating strong economic assets for the communities we invest in.
If you would like to learn more about our commercial real estate investment opportunities, contact us at (800) 605-4966 or email@example.com for more information.